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CenturyLink surprised investors with the decision to cut its dividend, even though the distribution was well-covered by free cash flow. Here’s management’s thinking.

On the company's fourth-quarter earnings conference call, management disclosed it would be cutting the telecom service provider's annual dividend from $2.16 to $1.00 per share. CenturyLink's share price had declined a lot since summer, driving its dividend yield over 15%, so clearly some investors anticipated this possibility. Even after the cut, CenturyLink's yield stands at over 7%.

Still, many were surprised, since management had regularly expressed confidence in the dividend throughout 2018, and the company's free cash flow handily covered the payout. So why did management make this decision?

What management had to say

On the company's earnings call, CEO Jeff Storey said:

... this change in policy isn't about a diminished view of our business. It is driven by our view that the long-term interests of shareholders are best served by proactively accelerating delevering to a new lower target range of 2.75 to 3.25 times net-debt to adjusted EBITDA ... By reallocating more of our capital to leverage reduction, we believe [we] will improve our cost of capital, return a significant amount of cash to shareholders at a very sustainable payout ratio, and provide additional flexibility to respond to market opportunities and any potential interest rate challenges that may occur.

In essence, management thinks even though CenturyLink could preserve the dividend, it would be better for the long-term health of the business to invest in the network, lower the company's $36 billion debt load, or make potential acquisitions. CenturyLink is also still saddled with some legacy copper-based products, such as landline phones and slower internet. Those headwinds are currently more than offsetting the company's fiber-based growth businesses, leading to current revenue declines on an overall basis.

The new debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) range is a three-year target, reflecting not only the debt paydown, but also EBITDA growth from investments in new products and capabilities.

An analyst pushes back

Many investors, and at least one analyst, may have been confused by management's decision, especially in light of pretty decent 2019 guidance. For the upcoming year, CenturyLink guided to a slight increase in adjusted EBITDA, from $8.94 billion last year to a range of $9.0 billion-$9.2 billion in 2019. However, the company's free cash flow guidance was $3.1 billion-$3.4 billion, down from this year's adjusted free cash flow of $4.22 billion, due to increased capital expenditures and the comparative effect of a lowered tax expense in 2018. Still, that free cash flow guidance would have handily covered the old $2.3 billion dividend payout -- though as we'll see below, just covering the dividend payout doesn't tell the whole story.

Analyst David Barden of Bank of America pushed back on management's decision to pay down debt early, asking, "...between the $6 billion of cash flow that you're gonna generate and the $3.6 billion of debt that matures and everything's trading above par, [it] doesn't really make sense to pay it down early."

Barden's point was that while CenturyLink has over $36 billion in debt, only $3.6 billion matures over the next three years. Those bonds are all trading "above par," meaning that bond investors did not appear worried about CenturyLink's ability to service that debt.

I'm not sure Barden's numbers were correct, unless something has changed since CenturyLink's last quarterly report. As of its third-quarter report, it looks like roughly $5 billion is set to mature in that time frame, with another $5.3 billion due the following year in 2022.

Year

CenturyLink Long-Term Debt Maturities (in millions)

2019

$651

2020

$1,202

2021

$3,115

2022

$5,323

2023 and thereafter

$25,785

Data source: CenturyLink Q3 10Q. Table by author.

Of course, CenturyLink doesn't necessarily have to pay all debt when due, if it can refinance it with new notes. However, given the rising interest rate environment and the market dislocation in December, it appears management didn't want to take that risk. If a company needs to refinance a lot of debt, there's no guarantee it will obtain the interest rate it likes, and if there's a market crash, debt markets may not be open at all.

CFO Neel Dev said, "Our view is paying down about a couple billion of long-term obligations per year over the next three years makes sense, but you have a different view."

Safety first

While it appears CenturyLink had the ability to pay the old dividend, reduce debt, and invest in its network, management apparently decided things were too close for comfort and is taking pre-emptive action. While dividend-focused investors are likely disappointed, the de-risking of the business was likely the safest move. Removing the debt maturity risk overhang could even help CenturyLink's flailing share price in the medium term, which investors shouldn't mind at all.